Portfolio Management: Fundamental for New Product Success

Product Innovation Best Practices Series

Portfolio Management: Fundamental for New Product Success Reference Paper #12

By Dr. Robert G. Cooper, Dr. Scott J. Edgett and Dr. Elko J. Kleinschmidt

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© 2000-201 Product Development Institute Inc. Product Development Institute Inc. and Stage-Gate are registered trademarks. Logo for Product Development Institute Inc. used under license by Stage-Gate International. Logo for Stage-Gate used under license where appropriate.

Authors: Dr. Robert G. Cooper - Dr. Scott J. Edgett - E. J. Kleinschmidt

There are two ways for a business to succeed at new products: doing projects right, and doing the right projects. Most new product prescriptions focus on the first route – for example on effective project management, using cross-functional teams, and building in the voice of the customer. Portfolio management, the topic of this chapter, focuses on the second route, namely on doing the right projects. A vital question in product innovation management is this: How should the corporation most effectively invest its R&D and new product resources? That is what portfolio management is all about: resource allocation to achieve corporate new product objectives. Much like a stock market portfolio manager, those senior executives who manage to optimize their R&D investments – to define the right new product strategy for the firm, select the winning new product projects, and achieve the ideal balance of projects – will win in the long run1. A Roadmap for the Chapter This chapter first outlines the four goals in portfolio management together with the various tools and techniques for achieving each goal: ! The first goal is to maximize the value of the portfolio for a given resource expenditure, and so various financial models, risk and probability models and a scoring model approach are presented as ways to realize this goal. ! The next goal is balance – the right mix of projects. Here the emphasis is on visuals and graphics: bubble diagrams, including the popular risk-reward diagram, as well as other variants of bubble diagrams; and more traditional charts, such as pie charts, which reveal the spending breakdowns in the portfolio. ! Achieving a strategically aligned portfolio is the third goal, and both bottom up approaches (where careful selection of individual projects results in a strategic portfolio) and top down method, such as strategic buckets, where the business’s strategy drives the portfolio, are described. ! The final goal is achieving the right number of projects for the limited resources available, and while most techniques do deal with resources constraints, resource capacity analysis is presented as a possible solution here. An assessment of popularity and results achieved reveals that the most popular portfolio methods aren’t necessarily the best, and indeed financial approaches yield the poorest portfolio. Recommended approaches for portfolio management in your business are highlighted next. Two fundamentally different approaches are described – both use the same tools highlighted above and described in detail later in the chapter, but the way the tools are applied is quite different: 1. The “Gates Dominate”: approach 2. The “Portfolio Reviews Dominate” approach. The pros and cons of the two approaches are outlined, along with some of the operational details of their use.

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This article is forthcoming as a chapter in The PDMA ToolBook for New Product Development, Wiley & Sons, 2002.

© 2000-2012 Product Development Institute Inc. Product Development Institute Inc. and Stage-Gate International are registered trademarks.

www.stage-gate.com 1

What Is Portfolio Management? Doing the right projects is more than simply individual project selection; rather it’s about the entire mix of projects and new product or technology investments that your business makes. Portfolio management is formally defined as follows [5,9]: Portfolio management is a dynamic decision process, whereby a business’s list of active new product (and development) projects is constantly up-dated and revised. In this process, new projects are evaluated, selected and prioritized; existing projects may be accelerated, killed or de-prioritized; and resources are allocated and re-allocated to active projects. The portfolio decision process is characterized by uncertain and changing information, dynamic opportunities, multiple goals and strategic considerations, interdependence among projects, and multiple decision-makers and locations. The portfolio decision process encompasses or overlaps a number of decision-making processes within the business, including periodic reviews of the total portfolio of all projects (looking at all projects holistically, and against each other), making Go/Kill decisions on individual projects on an on-going basis, and developing a new product strategy for the business, complete with strategic resource allocation decisions. New product portfolio management sounds like a fairly mechanistic exercise of decision-making and resource allocation. But there are many unique facets of the problem which make it perhaps the most challenging decision-making faced by the modern business: !

First, new product portfolio management deals with future events and opportunities; thus much of the information required to make project selection decisions is at best uncertain, and at worst very unreliable.

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Second, the decision environment is a very dynamic one: the status and prospects for projects in the portfolio are ever changing, as new information becomes available.

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Next, projects in the portfolio are at different stages of completion, yet all projects compete against each other for resources, so that comparisons must be made between projects with different amounts and “goodness” of information.

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Finally, resources to be allocated across projects are limited: a decision to fund one project may mean that resources must be taken away from another; and resource transfers between projects are not totally seamless.

Why So Important? Portfolio management is a critical and vital senior management challenge, according to a best practices – see Figure 1 [7,8]. Note how important the topic is rated by the senior executives in the business as well as the senior technology people. Additionally, higher performing businesses also tend to rate the importance of portfolio management much higher than poorer performers. Specific reasons for the importance of portfolio management, derived from the best practices study, are [7,8]: 1. financial – to maximize return; to maximize R&D productivity; to achieve financial goals 2. to maintain the competitive position of the business – to increase sales and market share 3. to properly and efficiently allocate scarce resources





4. to forge the link between project selection and business strategy: the portfolio is the expression of strategy; it must support the strategy 5. to achieve focus – not doing too many projects for the limited resources available; and to resource the “great” projects 6. to achieve balance – the right balance between long and short term projects, and high risk and low risk ones, consistent with the business’s goals 7. to better communicate priorities within the organization, both vertically and horizontally. to provide better objectivity in project selection – to weed out bad projects. Four Goals in Portfolio Management There are four common denominators across businesses when it comes to portfolio management: four macro or high level goals. The goal you wish to emphasize most will in turn influence your choice of portfolio methods. These four broad or macro goals are: Value Maximization: Here the goal is to allocate resources so as to maximize the value of your portfolio. That is, you select projects so as to maximize sum of the values or commercial worths of all active projects in your pipeline in terms of some business objective (such as long term profitability, EVA, return-on-investment, likelihood of success, or some other strategic objectives). Balance: Here the principal concern is to develop a balanced portfolio – to achieve a desired balance of projects in terms of a number of parameters; for example, the right balance in terms of long term projects versus short ones; or high risk versus lower risk projects; and across various markets, technologies, product categories, and project types (e.g., new products, improvements, cost reductions, maintenance and fixes, and fundamental research) 2. Strategic Direction: The main goal here is to ensure that, regardless of all other considerations, the final portfolio of projects truly reflects the business’s strategy – that the breakdown of spending across projects, areas, markets, etc., is directly tied to the business strategy (e.g., to areas of strategic focus that management has previously delineated); and that all projects are “on strategy”. Right Number of Projects: Most companies have too many projects underway for the limited resources available [7,8,9,10]. The result is pipeline gridlock: projects end up in a queue; they take longer and longer to get to market; and key activities within projects – for example, doing the up-front homework – are omitted because of a lack of people and time. Thus an over-riding goal is to ensure a balance between resources required for the “Go” projects and resources available. What becomes clear is the potential for conflict between these four high level goals. For example, the portfolio that yields the greatest NPV or IRR may not be a very balanced one (it may contain a majority of short-term, low risk projects; or is overly focused on one market); similarly a portfolio which is primarily strategic in nature may sacrifice other goals (such as expected short term profitability). Note that the nature of the portfolio management tool that one elects indicates a hierarchy of goals. This is because certain of the portfolio approaches are 2

Although the focus here is on portfolio management for new products, to the extent that technology resources used in new products are also required for other types of projects, portfolio management must consider the fact that new product projects compete against process developments, product maintenance projects and even fundamental research projects.



much more applicable to some goals than others: for example, the visual models (such as portfolio bubble diagrams) are most suitable for achieving a balance of projects (visual charts being an excellent way of demonstrating balance); whereas scoring models may be poor for achieving or even showing balance, but most effective if the goal is maximization against several objectives. Thus the choice of the “right” portfolio approach depends on which goal your leadership team has explicitly or implicitly highlighted. What methods do companies find most effective to achieve the three portfolio goals? The next sections outline the portfolio management methods, complete with strengths and weaknesses.

Goal # 1: Maximizing the Value of the Portfolio A variety of methods can be used to achieve this goal, ranging from financial models through to scoring models. Each has its strengths and weaknesses. The end result of each method is a rank-ordered or prioritized list of “Go” and “Hold” projects, with the projects at the top of the list scoring highest in terms of achieving the desired objectives: the value in terms of that objective is thus maximized. Net Present Value (NPV) The simplest approach is merely to calculate the NPV of each project on a spreadsheet; and then rank all projects according to their NPV. The Go projects are at the top of the list ... continue adding projects down the list until you run out of resources. Logically this method should maximize the NPV of your portfolio. Additionally, each project team usually determines the NPV for their project as part of their business case or capital appropriations request – so you’re using a number that’s already available. Fine in theory…. but: The NPV method ignores probabilities and risk; it assumes that financial projections are accurate (they usually are not!); it assumes that only financial goals are important – for example, that strategic considerations are irrelevant; and it fails to deal with constrained resources – the desire to maximize the value for a limited resource commitment, or getting the most bang for the limited buck. A final objection is more subtle: the fact that NPV assumes an all-or-nothing investment decision, whereas in new product projects, the decision process is an incremental one – more like buying a series of options on a project [13]. Expected Commercial Value (ECV) This method seeks to maximize the value or commercial worth of your portfolio, subject to certain budget constraints, and introduces the notion of risks and probabilities. The ECV method determines the value or commercial worth of each project to the corporation, namely its expected commercial value. The calculation of the ECV is based on a decision tree analysis, and considers the future stream of earnings from the project, the probabilities of both commercial success and technical success, along with both commercialization costs and development costs (see Figure 2 for the calculation and definition of terms). In order to arrive at a prioritized list of projects, the ECV of each project is determined. Next consider what resources are scarce or limiting. In the example in Table 1, R&D resources (people, but measured in terms of dollars) are thought to be the constraining or scarce resources – an R&D budget of $15 million. You may chose to use R&D people or work-months, or even capital funds, as the constraining resource.



Next, take the ratio of what you are trying to maximize – namely the ECV – divided by the constraining resource, namely the R&D costs per project (also in Table 1). Projects are rank ordered according to this ECV/R&D Cost ratio until the total R&D budget limit is reached: those projects at the top of the list are Go, while those at the bottom (beyond the total R&D budget limits) are placed on Hold. The method thus ensures the greatest “bang for buck”: that is, the ECV is maximized, for a given R&D budget3. Table 1: Expected Commercial Value Used to Prioritize Projects 1

2

Project Name

PV

Alpha

Beta

Gamma

Delta

3 Prob Tech Success

4 Prob Comm Success

30

.80

.50

63.75

.50

8.62

.75

.75

2

3

1.00

1.00

.60

.50

Echo

50

Foxtrot

66.25

5

6

7

8

Dev Cost

Comm Cost

ECV

ECV/Dev

3

5

5.0

1.67

3 Go

5

2

19.5

3.90

1 Go

1

2.1

1.05

6 On Hold

1

0.5

1.5

1.50

5 On Hold

.75

5

3

15.7

3.14

2 Go

.80

10

2

15.5

1.55

4 On Hold

.80

9 Rank & Status

The ECV column shows the value of the ECV (column 7), determined from data in the table (columns 2-6), using the formula in Figure 2. This ECV is divided by the limiting resource, namely Development Costs (EVC/Development Cost in column 8). Projects are then rankled 1-6 according to this ECV/Dev metric, until one is out of resources (column 9). The Development Budget is $15 Mil. Projects Beta, Echo & Alpha, totaling $13 Mil., are Go's. Source: Portfolio Management for New Products [6].

This ECV model has a number of attractive features: it recognizes that the Go/Kill decision process is an incremental one (the notion of purchasing options); all monetary amounts are discounted to today (not just to launch date), thereby appropriately penalizing projects that are years away from launch; and it deals with the issue of constrained resources, and attempts to maximize the value of the portfolio in light of this constraint. The major weakness of the method is the dependency on extensive financial and other quantitative data. Accurate estimates must be available for all projects’ future stream of earnings; for their commercialization (and capital) expenditures; for their development costs; and for probabilities of success – estimates that are often unreliable, or at best, simply not available early in the life of a project. A second weakness is that the method does not look at the balance of the portfolio – at whether the portfolio has the right balance between high and low risk projects, or across markets and technologies. A third weakness is that the method considers only a single financial criterion for maximization.

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This decision rule of rank order according to the ratio of what one is trying to maximize divided by the constraining resource seems to be an effective one. Simulations with a number of random sets of projects show that this decision rule works very well, truly giving “maximum bang for buck”!



Productivity Index (PI) The productivity index is similar to the ECV method described above, and shares many of ECV’s strengths and weaknesses. The PI tries to maximize the financial value of the portfolio for a given resource constraint [12,16]. The Productivity Index is the following ratio: PI = ECV * Pts / R&D Here, the definition of expected commercial value is different than that used above. In the Productivity Index, the expected commercial value (ECV) is a probability-adjusted NPV. More specifically, it is the probability-weighted stream of cash flows from the project, discounted to the present, and assuming technical success, less remaining R&D costs. There are various ways to adjust the NPV for risks or probabilities: via employing a risk adjusted discount rate used; or by applying probabilities to uncertain estimates in calculating the NPV; or via Monte Carlo simulation to determine NPV. This risk-adjusted NPV is then multiplied by Pts, the probability of technical success, and divided by R&D, the R&D expenditure remaining to be spent on the project (note that R&D funds already spent on the project are sunk costs and hence are not relevant to the prioritization decision). Projects are rank ordered according to this productivity index in order to arrive at the preferred portfolio, with projects at the bottom of the list placed on hold. Scoring Models as Portfolio Tools Scoring models have long been used for making Go/Kill decisions at gates. But they also have applicability for project prioritization and portfolio management. Projects are scored on each of a number of criteria by management. Typical main criteria include: " Strategic alignment " Product advantage " Market attractiveness " Ability to leverage core competencies " Technical feasibility " Reward vs. risk. The Project Attractiveness Score is the weighted addition of the item ratings, and becomes the basis for developing a rank ordered list of projects (Table 2 provides an illustration, using the six criteria listed above; projects are ranked until there are no more resources, in this case measured by FTE people). A sample scoring model is also shown in Table 3, with a more detailed list of criteria.

Scoring models generally are praised in spite of their limited popularity. Research into project selection methods reveals that scoring models produce a strategically aligned portfolio and one that reflects the business’s spending priorities; and they yield effective and efficient decisions, and result in a portfolio of high value projects [7,8].



Table 2: Prioritized Scored List of Projects - A Rank Ordered List

Project

Leader

Strat Fit

Prod Advtg

Market Attract

Core Comp

Tech Feasib

Reward

Epsilon

Peters

9

9

10

10

9

9

Project Attract Score 93.3

People FTE

Cum FTE

Status

20

20

Gamma

Cooper

10

10

7

7

7

7

80.0

20

40

Active Active

Alpha

Smith

8

7

7

8

8

9

75.0

15

55

Active

Delta

Scott

7

7

9

9

8

5

74.0

12

67

Active

Beta

Jones

7

7

6

6

8

6

66.7

20

87

HOLD

Omicron

Baily

8

6

6

8

7

5

66.7

20

107

HOLD

(resource limit: 70 FTE) 1. Set up a spreadsheet - list your Active, On Hold & proposed projects 2. Rank these projects according to some criterion ( e.g., Project Attractiveness Score or NPV) in this example, 6 screening criteria are used (see text) - Strategic Fit, Product Advantage, etc. the Project Attractiveness Score - the average of these 6 crtieria, but taken out of 100 - is used as the ranking criterion all 6 projects are good ones, with scores over 65 points out of 100 3. Include projects until you are out of resources (here measured by FTEs - full time equivalent people) here the first 4 projects are Active (note the resource limit of 70 FTEs); and the last 2 are put on Hold Source: Winning at New Products [4].



Goal # 2: A Balanced Portfolio The second major goal is a balanced portfolio – a balanced set of development projects in terms of a number of key parameters. The analogy is that of an investment fund, where the fund manager seeks balance in terms of high risk versus blue chip stocks; and balance across industries, in order to arrive at an optimum investment portfolio.

Table 3: A Typical Scoring Model for Project Selection [2,6] Factor 1 – Reward: